Don’t fret if the stock market’s recent volatility has confused you if you’re an investor. It might be worth your time to educate yourself on how traders can manage the risks and rewards of investing.
Here are some tips to help protect your wallet from unexpected losses:
1. Know Your Options
The options market is a way to bet that a stock or bond’s price will change. A call option gives the owner the right to buy a security at its current price while owning a put option gives the owner the right to sell it. For example, if you think XYZ stock can be bought for $100 in 3 months, you could buy a call option for $3 on every 100 shares. While you can only benefit from a stock price increase with this option, the price is virtually guaranteed.
Options can also be used to hedge risk by covering the downside of an investment. If you bought shares in Company A, trading at $50, you could buy a put option for $2 on every 100 shares. You now assume the risk that the stock price could fall below $50, which you can protect by buying a put option. In this case, your benefit is capped at $2 regardless of how low the stock falls.
2. Know How Many Risks You Can Take
While you can’t eliminate risk entirely, you can control it by knowing how much of your investment capital you can afford to lose. Let’s say your brokerage lets you borrow $40,000 to buy ten shares of XYZ stock at $100. That brings the total value of your bet to $400. If you lose all of your money with XYZ, your loss is $400.
If you’re taking a small ($20-$40) position in a stock, you may risk losing more. However, if your initial investment was significant ($400 on ten shares), it’s unlikely that you’ll be wiped out.
Recession proof stocks can be an excellent supplemental investment because they have a small degree of risk. They can be bought on margin and turned into 100+ dividend-paying stocks through the DRIP (dividend reinvestment program).
While buying options with borrowed money is a way to profit from market movements, many traders use margin to buy more stock or provide extra security for loans. For example, when people trade on margin, their cash doesn’t cover their investment capital. Instead, it’s backed by the assets in their brokerage account.
Margin can be used to buy much more stock than you otherwise could. For instance, if you want to buy ten shares of ABC stock and have $5,000 in your account, a broker might let you borrow $5,000 from your brokerage. A $100 margin deposit allows you to raise $10,000 within minutes.
Margins are measured in percentage points. Too high a margin and you may be required to post as much as 20% in cash. While this would prevent you from opening a new trade, it would also limit your profits if a stock went up. A much safer margin level is 1%, which gives your account the ability to cover up to 10% of all trades.
4. Strict Trading Rules
Even the most experienced traders occasionally make costly mistakes. Just as you should discipline yourself to avoid losing more than your initial investment, you should have rules for your trading account informing others of your tendencies. The goal is to lower the chances of a disastrous trade.
For example, trading with a more extensive account balance means you have fewer shares and options available at any given time. This means you have less incentive to buy on dips and sell on spikes. Instead, the goal is to go in with a plan that makes sense.
The key to properly managing risk is diversification. Not only can you buy options and stocks from different companies, but you can also invest in a range of industries. For example, if you have an extensive portfolio of mutual funds or stocks from one industry, your failure to sell could result in an unnecessary loss.
It is crucial to always be in the know with business news. It helps you make a better stock market forecast and gives the latest news on business developments and financial news on the trend in the market.